By Noah Rosenfarb
The Taxpayer Relief Act of 1997 created a new type of Individual Retirement Account (“IRA”) named after Senate Finance Committee Chairman, Senator William V. Roth, Jr. Roth IRAs offer an unparalleled tax incentive – while contributions to Roth IRAs are not tax-deductible (unlike traditional IRAs), all distributions from a Roth IRA are tax-free.
What are the Advantages?
Similar to traditional IRAs, the dividends and interest generated by a Roth IRA, are not taxed while they are accumulated in the IRA. However, Roth IRAs offer a significant bonus – tax-free withdrawals. Although contributions are not tax deductible, withdrawals at age 59½ (earlier if you use it to buy a first home) are tax-free as long as it has been in the account for at least five years. And, there is no requirement to withdraw any money at age 70½; and, upon death, beneficiaries will not owe any income taxes upon withdrawal.
Facts on Converting Traditional IRAs to a Roth IRA
You can convert all or part of your traditional IRA to a Roth IRA. However, because contributions to a Roth IRA are non-deductible, you must pay tax on any taxable amounts you convert. The conversion is treated as a penalty-free premature distribution. Therefore, it must be listed on your tax return as taxable income, and that income could move you into a higher tax bracket.
For 2010, conversion income can be reported 100% in 2010 or equally in 2011 and 2012.
Signs for a Conversion Candidate
While there are no hard and fast rules to identify conversion candidates, here are some “signs” to look for:
- Income for the taxpayer will be “artificially” lower in 2010 (or 2011 and 2012) than in future years. In divorce cases, look for alimony beginning late in 2010 to signal an opportunity for the alimony recipient. For business owners, if they have carry-forward losses, they may want to accelerate income. For entrepreneurs starting a business, they may anticipate reduced income in their first few years.
- The taxpayer will have assets outside of the retirement plan to pay taxes. If this is the case, the taxpayer is essentially making an additional contribution to their retirement savings.
- If you expect to be in the same or higher tax bracket when you retire.
Tax Rates – What Does the Future Hold?
To help make assumptions about the future of tax rates in the US, we can look backwards to see how rates have changed over time.
1918: Tax rates were raised to 77% in order to help pay for World War I. Tax rates started to fall in the years afterwards.
1932: The top rate is raised to 63%. This rate increased in the years leading up to and including World War II.
1945: Income over $200,000 (about $3 million in today’s dollars) was taxed at 94%. Tax stayed over 90% until 1964 when it was lowered to 77%. Rates then consistently declined until…
1974: ERISA (Employee Retirement Income Security Act of 1974) enacted to protect workers after business owners increased use of tax-deferred savings strategies.
1991: The top rate was increased from 28%, where it had bottomed out, to 31%. Since, rates have climbed to 35%.
Most economists agree tax rates will go up over the next 30 to 50 years. Even with that expectation, it is possible future taxes will not be income related, but rather consumption driven, like a Value Added Tax, which would not impact retirement plans.
The Best Reason to Roth – the “Do Over”
Incredibly, the tax code allows those that convert to later change their mind and “go back” to a traditional IRA before filing your tax return. This “do over” provision is potentially the most valuable in a volatile stock market. Here is an example of how this might work for the owner of a $200,000 IRA.
The owner converts all $200,000 to Roth by opening 2 new Roth IRA accounts of $100,000 each at the beginning of 2010. The accounts are invested in different types of investments (US Large, Mid or Small Cap, International, Emerging Markets, etc.). On October 14th, 2011 prior to filing a tax return (but after filing for extensions), one account is valued at $85,000 and the other is worth $125,000. The owner can elect a “do over” on the $85,000 account, forgoing the tax on conversion, and providing an opportunity to convert again on January 1, 2012 – less than 3 months later.
For the account with $125,000, the owner can keep the conversion, and pay tax on the $100,000 original amount.
If nothing else, it is worth reviewing your personal situation or that of your clients with an experienced financial professional or tax accountant to discuss the benefits of a Roth IRA conversion strategy. 2010 presents a unique opportunity because of the timing of tax payments (in 2011 and 2012) and the “do over” provision means there is nothing to lose by trying.
Divorce Practice Tips – 5 Situations to Discuss Conversions with Clients:
- Clients not anticipating withdrawals from retirement accounts for 20 years or more, with the ability to make the conversion tax payment from other savings will almost always achieve greater after-tax income in retirement.
- The client suffers from Recently Acquired Income Deficiency Syndrome (RAIDS) – income in the year of divorce is lower than what would reasonably be projected in the future. Plus, if the RAIDS patient is paying alimony or unallocated support, they have a “new” deduction.
- Your client has paid high legal and accounting fees which are deductible, and will not have income to offset the deduction. By converting now, they will artificially increase income, and will have an offsetting deduction from deductible fees. Note, however, that the Alternative Minimum Tax is often a limiting factor.
- Your client accepted an alimony buy-out and has no earned income. These clients often can benefit significantly from a program of converting a portion of their IRA each year while still maintaining a low tax burden. I have a handful of clients that can covert $30,000 to $50,000 per year tax-free.
- If an IRA holds non-traditional assets such as an annuity, note, real estate, or business interest, the current value may be depressed due to current economic conditions. This may make a conversion especially attractive.
Noah B. Rosenfarb, CPA is Managing Director at Freedom Divorce Advisors where he provides sophisticated tax and financial advice to affluent divorced women. Mr. Rosenfarb integrates life planning with financial planning to ensure clients experience the maximum benefits of affluence post-divorce. His holistic approach increases the probability of leading a life that is filled with prosperity – the kind that is measured more by personal happiness than merely by currency.
Reprint with permission.